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IAC: The Unraveling Of An Empire


Two years ago, Barry Diller was positioning himself as the Internet's first swaggering Hollywood-style mogul. Diller, the former head of Paramount Pictures (VIA) and founder of Fox Television Network, (NWS) was angling to dominate entire sectors of online commerce.

As CEO of IAC/InterActiveCorp (IACI), he gobbled up key Web players in markets from mortgage banking to real estate. And on Aug. 8, 2003, Diller placed the crown on his empire by completing his buyout of travel powerhouse Expedia Inc. He boasted that his widening position on the Net would give IAC "a role in defining the economic laws" of entire industries -- starting with travel. Wall Street stars bought the vision. Legendary mutual fund manager Bill Miller took a 16% stake in IAC, saying Diller's Internet colossus reminded him of Warren E. Buffett's Berkshire Hathaway Inc. (BRK)

Like many Hollywood extravaganzas, however, Diller's production in the last two years has strayed from its script. It has been victimized, in part, by changing industry trends: As travel picked up in the grim aftermath of the 2001 terror attacks, Expedia and its stablemate, Hotels.com, lost much of their leverage over hotel chains. At the same time, Diller -- a famously tough boss -- oversaw an exodus of top managers, especially from the travel businesses. And he unsettled Wall Street, on occasion, with combative behavior. The upshot: As other Net stocks, from Yahoo! (YHOO) to Google (GOOG), have surged, IAC has tumbled 38% since Diller's Expedia buyout.

Now, as the Hollywood press might say, it's Splitsville. Frustrated that woes at the travel divisions were dragging down the stock, Diller moved last year to hive off travel from the rest of IAC. And on July 19, shareholders O.K.'d the plan to cleave the company in two. The travel businesses, with $2.1 billion in projected revenue, according to Merrill Lynch & Co. (MER), will start trading in early August as Expedia Inc. This will bundle Expedia with troubled Hotels.com, deep-discount travel site Hotwire, and travel-advice site TripAdvisor.

IAC will be left with a grab bag of companies with revenue this year expected to reach $5.7 billion. They range from Ticketmaster and loan broker LendingTree to newly acquired search engine Ask Jeeves (ASKJ). Diller will remain chairman of both companies, but he has installed longtime lieutenant Dara Khosrowshahi as Expedia's CEO.

Many on Wall Street are quick to brand Diller's $10 billion dealmaking spree a bust. They need look no further than the travel division. While the group accounted for 34% of the combined company's $6.2 billion in revenue last year and 61% of its operating earnings before amortization, travel growth has slowed dramatically. It tumbled to 20% last year from 41% in 2003. Says Diller: "If you want to make the case that the meteoric growth is over, it's totally true.... Both Expedia and Hotels thought it would go on forever. But the leverage goes back and forth. It has in every business I've ever been in."

Still, don't shed any tears for Barry Diller. While the split has cut down his colossus, many of the individual pieces are still worth plenty. Despite its growth slide, Expedia continues to amass 30% profit margins before most noncash charges. Ticketmaster and shopping channel HSN are profitable, if slow-growing. And on July 19 Diller closed the $1.8 billion deal for Ask Jeeves. Backers think it has the potential to become the hub of a Web media network that feasts on the same ad flow that powers Yahoo and Google.

The question, though, is whether the 63-year-old Diller has the management skills and temperament to take on such heavyweights. Indeed, the short life of his Internet empire was marked by disputes, a measure of internal chaos, and at least one strategic blunder.

At the center of the drama was Expedia. In 2002, when Diller bought a controlling stake in the company from Microsoft Corp. (MSFT) for only $1.5 billion, he established himself as one of the savviest of Net investors. From its late 1999 initial public offering through 2003, the travel service soared as much of the rest of the dot-com economy collapsed. Expedia's stock rose tenfold.

THE EARLY DAYS

In those years, Expedia raced ahead with a mix of startling innovations and brass-knuckle tactics. Led by brash CEO Richard Barton, the Web service notched its biggest triumph during the slack years after the attacks of 2001. The hotel industry was sitting on millions of empty rooms. Barton and his team negotiated to buy the rooms at heavy discounts. When they found customers, they marked up the rooms 25% to 30%, often bundling them into broader packages.

Profits exploded, and Expedia continued to flex its muscles. The company enraged hotel chains by going around them to hammer out special deals with owners of individual hotels. The result: Customers could often get some Hilton (HLT) rooms cheaper at one of Diller's sites than at Hilton.com. This led to a rush of growth and earnings for Expedia -- and the prospect that the company would continue to steamroll its way to dominance in travel.

As Diller moved to consolidate his majority grip on Expedia in 2003, he continued to push hotels for deep discounts. But as the economy improved, hotel chains regained much of their lost leverage -- and they pushed back hard. They agreed to give IAC access to rooms at more hotels, but only if the company stopped undercutting their prices. The chains insisted on smaller markups and limited IAC's allotment during peak seasons. They also drove traffic to their own sites by refusing to give IAC customers frequent-stay points. The upshot: Last year, Hilton steered 90% of its online customers to its own sites. That's up from 75% from 2003.

Diller admits he encouraged his executives to squeeze hotels. But he insists that it was overzealous underlings, since departed, who squeezed too hard. "It's unwise, when leverage is on your side, to take too much. It will come to tears," a philosophical Diller says now. "And that's what happened.... I didn't know the extent of it." Responds one former Expedia exec: "[Diller's] head was not in the sand. He was cheering us on."

Management upheaval added to the confusion. Diller inherited a crack team at Expedia, headed by Barton. In 2002, shortly after buying his first company, Diller lauded Barton for transforming an industry. He even went so far as to describe Barton as a latter-day Henry Ford. Yet the two often clashed. And when Diller, over employees' objections, imposed a policy eliminating Expedia stock options on Jan. 1, 2003, Barton had had enough. Weeks later, he quit and moved to Italy.

That triggered a management exodus from Expedia. Of nine top execs in mid-2001, only two remain: the human resources director and the head of a small luxury unit. Diller says many who left were coasting as they awaited rich stock options. "Ever hear the term 'rest and vest'?" he asks. Departed Expedia execs disagree. Former CEO Erik Blachford "worked himself into a hospital to appease Diller," says one.

The personal split between Diller and Barton's loyalists remains. After returning from Italy in 2004, Barton, who asked not to be quoted in this story, has hired more than a dozen Expedia managers for his startup, Seattle-based Zillow.com -- a potential competitor of IAC's RealEstate.com. The most recent addition is Barton's successor, Blachford, who left Expedia last year and joined Zillow's board.

It may just be chance, or serendipity -- one of Diller's favorite words -- but as the founding team departed, the travel group appeared to lose its knack for innovation. Initiatives stalled. A long-expected strategy for Hotels.com -- one less focused on bargain rates -- didn't materialize. And a long-anticipated IAC loyalty program, designed to counter moves by the hotel chains, has been plagued by delays.

Through 2004, IAC delivered weak earnings and a string of bad news. Diller couldn't hide his frustration. In a tense conference call with analysts in August, he barked that he was tired of answering the same questions about hotels. "As Judy Garland once said: 'I'll sing all night,"' he snapped at an analyst. Mark Mahaney, then an analyst at American Technology Research Inc., wrote that Diller's "rambling, imploding performance" on that call helped spark a 19% one-day drop in IAC's stock, to $23.

"BROKEN BRANDS"?

In October, with IAC shares at $19, Diller was fed up. He argued that the travel business, long viewed as the company treasure, was holding down the stock. On Dec. 21 he unveiled his plan to break IAC in two.

Even as investors try to make sense of the two companies, troubles continue on the travel side. The most worrisome is Hotels.com, where sales have shrunk for two quarters. Another laggard is Hotwire, which competes with Priceline.com in name-your-price discount travel. After a glum first quarter for IAC, Legg Mason Equity Research (LM) analyst Scott Devitt declared Hotels and Hotwire "broken brands." Devitt says: "The entire model was based on getting the lowest price and the maximum margin, and access to that kind of inventory and margin have deteriorated."

The good news: Thanks in part to the wave of bad press, Diller's two companies may well emerge from the split-up at bargain prices. Both generate plenty of cash -- an estimated $640 million on the travel side this year and $700 million in the rest of IAC. Legg Mason Capital Management figures that IAC, which is currently valued at $16 billion and holds $4 billion in cash, trades at a low 10 times this year's likely cash flow.

More important, solutions to the travel problems may be on the way. Khosrowshahi says the long-awaited loyalty program, for example, will finally make its debut this fall. The Web site for Hotels.com is getting a redesign in August. And he predicts that earnings will rise 50% at Hotwire. Still, any turnaround is unlikely to rekindle Diller's imperial visions -- at least not for a while. That script is in rewrite.

By Timothy J. Mullaney in New York


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